Yen's rally resumes, hitting carry-trade

Dollar rises against euro after U.S. manufacturing data

By

WanfengZhou

NEW YORK (MarketWatch) -- The Japanese yen resumed its rally against most major currencies Thursday, touching a 2 1/2-month high against the dollar as investors continued to unwind the so-called "carry trades" that had benefited from a low yen for so long.

Meanwhile, the dollar rose against the euro after a report showed the nation's manufacturers increased production in February. A separate report showed the year-over-year increase in the core personal consumption expenditure price index running above the Federal Reserve's target zone, providing further support for the greenback.

"Yen extends gains across the board as the aftershocks of this week's equity sell-off begin to reverberate from Asia to U.S.," said Ashraf Laidi, chief foreign-exchange analyst at CMC Markets in New York. "As volatility lifts up and risk appetite falls, yen becomes the gainer as traders unwind their carry trades, which were used to finance high yielding currencies and equities."

Late in New York, the dollar was quoted at 117.52 yen, compared with 118.38 yen late Wednesday. In intraday trading, the dollar had fallen to a low of 116.94 yen, the weakest seen since Dec. 13.

The euro stood at $1.3184, compared with $1.3233.

The British pound traded at $1.9587, compared with $1.9643. The dollar changed hands at 1.2219 Swiss francs, compared with 1.2186 francs.

Carry trade refers to the practice of investors borrowing a low-yielding currency -- such as the yen -- that they investing in higher-yielding currencies and assets. Japanese interest rates currently stand at 0.5% following a long period of deflation, making them the lowest among major economies. See full story.

U.S. stocks closed lower on Thursday, even as they recovered from an early steep fall. Major Asian markets, European markets, and emerging markets all posted losses.

Market sentiment

Investors' risk appetite fell sharply in recent sessions on uncertainty over the outlook for the U.S. economy, fears of the potential knock-on impact from sub prime lending market woes and worries over Iran's nuclear plans.

"Everybody is nervous and wondering when the next shoe will drop," said David Watt, senior currency strategist at RBC Capital Markets. "When it first happened, everybody was just stunned and shocked, today is the day when a lot of people are going to wonder is this something fundamental or is this shorter-term?"

The yen's rally started on Tuesday when it jumped more than 2% against the dollar and euro as greater aversion to investment risk triggered by a big slump in stocks in Shanghai prompted traders to unwind carry trades.

"The yen is really being traded like the single barometer of global risk appetite, and for that reason, we're seeing yen gains" when equity markets are under pressure, said Lara Rhame, senior currency strategist at Credit Suisse First Boston.

"I don't think this necessarily makes a lot of fundamental sense, but that's the way the market jitters are materializing right now," she said.

Outlook for carry

Rodrigo Rato, managing director of the International Monetary Fund, on Thursday reiterated his concerns about the dangers of carry trades, sparking buying activity in the yen.

Hiroshi Watanabe, Japan's top financial diplomat, said overnight that the unwinding of yen carry trades has not yet started, indicating that currency moves would be bigger when such unwinding begins. He also said that carry trades were a "two-way bet."

Despite the current bout of turmoil, some strategists say fundamentals remain positive for continued investment in the carry trade in coming months. But caution is needed, and investors should become increasingly selective.

"We disagree with the carry trade Cassandras who fear an indiscriminate unwinding of FX carry trades," said Monica Fan, global head of foreign-exchange strategy at RBC Capital Markets, in a note. "We believe risk appetite will recover as the Fed is primed to cut rates and the sell-off in equities and risky assets reflects short-term profit taking."

Fan recommend investors selectively buy high yielding currencies that are supported by stronger current account positions and/or can benefit from rising commodity prices.

Manufacturing, inflation data

Providing grist for the currency markets, the Institute for Supply Management said its February manufacturing index rose to 52.3% from 49.3% in January. The consensus forecast of estimates was for the index to rise to 50.0%. Readings above 50 indicate expansion. See full story.

"Renewed growth in manufacturing employment is an unexpectedly pleasant surprise," said Michael Woolfolk, senior currency strategist at the Bank of New York. "Today's ISM report is the first unequivocally positive sign from the manufacturing sector in some time. If this continues, it may provide some much-needed support to the economy as the U.S. housing market takes its next leg lower."

Separately, a Commerce Department report showed U.S. core consumer prices rose 0.3% last month, in line with expectations, but the year-over-year increase of 2.3% stood above the Federal Reserve's target zone of 1% to 2%. See full story.

The odds that interest rates will be cut by the end of the first half of the year rose slightly, but were well below their highest levels. Markets were pricing in a 60% chance that the Federal Reserve will lower its target for overnight rates to 5% from 5.25% by June. Before the release of the ISM data, the odds of a rate cut had stood at as high as 86%, vs. 58% late Wednesday.

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